Monday, 29 September 2008

Blow It All Up; Go Back to the Drawing Board

That would be my advice to Congress after the House repudiated the $700 billion bailout plan, 228-205. I've read enough online comments to realize that Wall Street is stunned, perplexed, and not a little bit irritated. But I think that reaction just underscores a growing gulf between the two streets, Wall and Main. Joe Sixpack hated this bill with a fury, and that's what Congress has been hearing.

Now I think legislators have two choices (short of nudging 12 members into changing their votes):

Incrementalism (if you like sports metaphors, call this “going short”): Scale back the size and scope of the rescue. One suggestion floating around would provide for $150 billion in low-cost loans to companies weighted down with too many bad assets backed by U.S. home mortgages.
Advantages: Easier to marshal political support on both sides of the aisle. Sidesteps knotty questions of what to pay for hard-to-value toxic financial waste. Minimizes government involvement.
Disadvantages: May be too little to restore confidence and fix ailing firms. Could leave the Treasury Department and Fed injecting funds into the U.S. financial system and stamping out fires for years to come as the economy muddles along.

The “Bear Hug” (or, “going long”): Have the government aggressively take ownership stakes in financial firms in return for buying bad assets and pumping in capital. Try to weed out weaker companies that are insolvent and so badly run they don't deserve to survive.
Advantages: If we can get our arms around the whole problem at once, that could reduce the chances of a drawn-out resolution where good money is thrown after bad. Protects taxpayers better from losses. Also, a government that drives hard bargains (as Sweden did with such a program) will motivate financial firms not to seek Treasury help and to find private funds on their own to recapitalize.
Disadvantages: Wall Street won't like this one, after the tantalizing mirage of being able to dump their toxic waste at above-market prices under the original Paulson plan. And politicians too may balk at the size of the effort and the ideological implications.

Time to get a dialogue going. Two places to start: what Chile and Sweden did during their financial crises, with good outcomes.

The Unraveling of the Money Markets: The Flip Side of Efficiency

To the uncritical mind of finance professors who see the markets with the eye of a P.R. agent, the changes that have taken place in the past thirty years in the financial markets were a series of inspired events brought about by visionary bankers, insightful academics and bold traders. The result, naturally, was “sophisticated” and “efficient” markets which benefited all.

In reality, finance is a dialectical discipline. Its development follows the logic of internal evolution of finance capital which turns the phenomena to their opposites – commerce to speculation, hedging to arbitrage, equilibrium to volatility, just to name a few. The most benign phenomena then reveal a hidden side that is in contrast to their docility. Such is the case with the “efficient” markets.

By efficient markets, the academics mean a market where, thanks to arbitrage, the borrowing costs are low and capital is allocated in the optimum way. In practice, this means markets in which capital never stands idle. It is employed at all times, earning however small a return. In a time of crisis, this constant engagement turns into entanglement. To free the capital then, it is necessary to unwind; mere selling would not do. Search for “unwind financial markets” in Google for various instances of unwinding.

In money markets, two areas oil the efficiency engine. One is the tri-party repo market which I described in Credit Woes. The other is the even larger securities lending market – called “sec lending” by everyone in the industry – whose size is well above the tri-party’s $4 trillion daily transactions.

The sec lending market is driven by short selling, or shorting, which is selling something you do not have. Outside the financial markets, the practice amounts to fraud; if you sell a house, or a car, or a farm you do not have, you would probably go to jail. In the financial markets, the practice is legal and very common. With the ownership requirement eliminated, the buy-sell sequence could be reversed; instead of buying first and selling later, you could sell first and buy later. So if we think that, IBM, for example, might fall, we call our broker and short 1000 IBM shares. We hope to buy them back later when the price falls.

For every seller, there is a buyer. Someone must have bought the 1000 shares we just sold. But we did not posses the shares. How are we going to deliver the shares to the buyer? That brings us to sec lending.

Take a large investor – a mutual fund, for example – that owns tens of billions of dollars worth of securities. In the modern financial markets, there is no physical certificate. All securities, rather, are held in street name, for the fund, by a custodian bank.

In the efficient capital markets, with the constant struggle by funds to improve their performance by even 1/100th of a percent, these securities are a potential source of addition income to the funds which own them. So as part of an active arbitrage strategy, the custodian bank approaches the fund and makes the following pitch:

We are holding large securities positions for you that currently sit idle. Through our sec lending program, we could lend all or part of them to short sellers. You need not worry about risk. Among various precautions, we indemnify the lent securities, so that should you suffer any loss, we would make you whole.

As collateral for the lent securities – you will even have the option of telling us whom not to lend to – we would receive cash collateral from the borrower (short seller). We would invest the cash and share the proceeds in some equitable manner, say 80-20, where you get 80% and we get 20% .
After the securities owner (the fund) agrees, the custodian bank inform short sellers that it is open for business.

Assuming the same 1000 IBM shares is trading at $120 per share, the following then takes place:

1. The custodian bank “delivers” 1000 shares, worth $120,000, from the fund’s account to the short seller, or the borrower (of stock)

2. The borrower posts cash collateral to the bank equal to $122,400, which is 102% of the value of the borrowed stock.

(Upon termination of the short sale, the securities are returned to the fund. The bank returns short seller’s $122,400, plus accrued interest calculated at the Fed Funds rate.)

3. The bank invests $122,400. If the spread between what the bank earns for this investment and the Fed Funds rate is 10 basis points, the interest income would be $122.50, which is split in a pre-agreed manner between the bank and the fund.

This is the most critical step. Since the interest income is the difference between what the bank can earn and the Fed Funds rate, there is a strong incentive for the bank to invest aggressively. In the mean time, short sellers do not sit on their positions for long, so the investment has to be short term, which is the realm of money markets.

There are two ways to increase – to enhance, in the language of marketing brochures – the return on a money market fund: to go down the credit ladder, or to extend the term. The first option exposes the fund to the risk of loss due to a downgrade. The second, in addition to a credit downgrade, locks up money for a period ranging from one week to just under one year.

Imagine now that the borrower of shares is Lehman Brothers. The owner of the shares – a mutual fund, in our example – becomes concerned about the health of the firm and instructs the bank not to deal with Lehman. The lent shares must now be recalled and $122,400 with the accrued interest returned to Lehman. If the bank has locked the money in a money market fund that has an as-yet-in-the-future maturity, it has to liquidate the position. If the money market fund is aggressive and has invested in junk mortgage securities that have dropped in price, the hit to the principal is even more pronounced. The custodian bank must then make up the shortfall, an act that requires an immediate infusion of cash. It is in this way that short term markets come under pressure, which is why the Treasury immediately responded by guaranteeing the principal in money market funds; large custodian banks with trillions of dollars in custodial accounts, not to mention many “boutique” firms, are actively engaged in sec lending. The efficiency of markets brought about by the sec lending business is one of the primary sources of disorder in money markets that is reflected in unprecedented Fed Funds/Libor/OIS spreads.

That is also why the stock price of custodian banks took a beating on September 18, a process that continues to date. Check State Street, for example, whose violent price swings on that day showed that traders were aware of the role of the “custody banks” and the vulnerability that follows from their business model.

All in all, the individual stock price changes, like today’s 700 plus point drop in the Dow Jones, are mere consequences. That index could rebound tomorrow – or the day after. The unraveling of the money markets, on the other hand, is here to stay – well beyond tomorrow and the day after.

And Poof! There Goes $700 Billion

My working title for this blog entry was “Now Serving: a $700 Billion EntrĂ©e Garnished With Political Fig Leafs.” But that was a little too long.

The storyline of the Wall Street bailout: King Henry triumphed, while politicians harumphed and bloviated and found tiny fig leafs to cover their exposure before an irate electorate (voters go to the polls in a few weeks). Paulson essentially won what he wanted, as legislators skirmished in the margins of relevance. Some highlights of what we got:

1. The Democrats can crow that they clamped down on executive pay excesses for anyone receiving bailout funds. In truth, the provisions are pretty limited in scope and meek – and don’t always make sense. Example: the CEO of a company getting rescued gets to keep his existing golden parachute, but any new CEO hired won’t be entitled to one. Come again? So the CEO who presided over a financial firm that acquired a lethal amount of toxic waste gets off scot free, while a fresh leader who works to right the ship gets punished?

2. Not to be outdone, the Republicans inserted their own piece of idiocy. Seeking a free-market fix, they came up with an “insurance” idea. Financial firms could opt to keep their bad assets and guarantee their value by buying special insurance through the government. Sounds like someone was drinking the Wall Street Kool-Aid. The Street, if you recall, protested vigorously that their toxic waste has a “fair value” much higher than what they could get in today’s troubled markets. Taking out insurance only makes sense if you really, really believe that and think you won’t get a sweet price from the government. Move on, nothing to see here.

3. Anyone who gets more than $100 million of bailout funds MUST give the government preferred bonds or rights (known as warrants) to buy stock. That’s promising, as it allows the Treasury to claw back some profits. That will be especially critical if investments bought with the $700 billion turn out to be duds. The caveat: the language in this section is vague and if Paulson doesn’t support the concept (and I don’t think he does), he might not push too hard to get a good deal.

Sunday, 28 September 2008

Why a Reverse Auction Won’t Work

Exhausted Congressional leaders, after hours of testy negotiating, reached a deal on the great Wall Street bailout. The devil, of course, is in the details. But from what I gather, the central feature of the plan was preserved: the Treasury will buy up to $700 billion of bad assets backed by U.S. home mortgages.

The latest version of the plan also requires financial firms to give the Treasury warrants in return for getting rescued. A warrant allows you to buy shares in a company at a fixed price. So if, say, Invest-orama receives a bailout, and then its shares soar from $20 to $40, the government can profit. That’s something at least.

From where I sit though, the troubling problem remains how much to pay for this toxic waste (see my previous blog entry). Warrants don’t eliminate that issue; they just add a complicating dimension to it. A financial firm that might’ve sold a deteriorating bond at 55 cents on the dollar might revise the price upward to 60 cents to account for the warrants.

But how to arrive at that original price, whether it’s 55, 40 or 30 cents on the dollar? There’s a huge spread between what owners of these assets think their investments are worth and what a buyer in the current jittery markets will pay. Fed Chairman Ben Bernanke has floated the idea of a reverse auction. Whereas a normal auction has one seller and many buyers, a reverse auction has one buyer and many sellers.

Reverse auctions make sense for buyer-designed products (a buyer might issue, say, detailed specifications on a car door latch that it wants manufacturers to bid on the right to make) and commodities. If you want to buy 100 barrels of road salt, in a reverse auction there could be 18 sellers that submit continuous bids, each lower than the one before, until reaching the best price.

The problem is that Wall Street isn’t trying to unload barrels of road salt. On the contrary, the toxic financial products held by these firms are complex, hard to value, and often unique. Each mortgage-backed bond is yoked to a specific batch of U.S. homes, and each home in turn has its own history of timely or late payments, its own odds of foreclosure. So Bond A, offered at 40 cents on the dollar, may turn out to be a much riskier (and worse) deal than Bond B at 60 cents.

Also a reverse auction is too scattershot, spraying money through the system without regard to who receives it or how much they get. In a financial crisis, we need a more sophisticated and aggressive approach. Some companies will die; they deserve to. The government should review balance sheets, let insolvent firms perish and pump funds into those that can be rehabilitated (or need to be, for the stability of the system).

I would NOT vote for this bailout plan. A better idea waits in the wings. Check out what the economist Nouriel Roubini proposes; it’s a much smarter way to go and better protects taxpayer funds.

The financial system won’t suddenly implode on Monday without a bailout package. It’s under stress, but we still have some time. Why not do this right?

Saturday, 27 September 2008

Four Reasons to Punt on Paulson’s Bailout Plan

This weekend Congress will try to thrash out an agreement on a Wall Street bailout. Treasury Secretary Hank Paulson wants to spend $700 billion to buy distressed bonds and other assets that are backed by soured U.S. home mortgages. Okay, let’s pause and take a deep breath and look at four big reasons why NOT to.

1. There is no way to know the right price for this stuff, leaving it likely the government will overpay. The seller of a bad mortgage-backed bond may claim its “fair value” is 60 cents on the dollar. Right now, amid jitters over tightening credit and a still-deflating housing bubble, the best offer on the open market may be 20 cents. So do we trust government accountants – toiling under time pressure, analyzing thousands of different (and complex) securities, probably using vague guidelines – to arrive at the proper price?

2. The U.S. taxpayers will pick up the lousiest of the lousy, probably at the worst prices too. There’s estimated to be more than $2 trillion worth of bad mortgage-related assets out there. So, shocking as it may seem, a $700 billion check doesn’t come close to doing the trick. Financial firms will surely cherry pick the wormiest fruit to offload while pretending it’s better than it is. Their knowing more about the individual investments boosts the chances of the government getting hoodwinked on some of these deals.

3. This is a horribly inefficient use of resources in a free market system. The bailout program could become a full employment act for the investment banking industry. For starters, the government would need consultants and specially trained employees to help it process the deluge of applications from financial firms seeking to shed their toxic waste. Then the decisions: what to buy, how much to pay (the research on that alone should keep a platoon of analysts busy around the clock). Then someone has to manage the assets, decide when to sell them, execute the sales.

4. Letting financial firms off the hook sends the wrong signal and sows the seeds for the next crisis. The message: Go ahead and take huge risks, make bad bets, overextend your capital – the taxpayers will be waiting in the wings to pick up the pieces. It encourages the bad actors to keep behaving the same risk-crazy way they have been, and the good ones to follow suit in order not to fall behind.

Thursday, 25 September 2008

The Sly Sage of Omaha

Sometimes, to know what a man really thinks, you need to watch his feet, not his lips. Words are the units of an often-cheap currency that’s easily manipulated and debased. And so when Warren Buffett, finance’s plain-spoken wise man, voices support of a $700 billion plan to bail out Wall Street, one might reasonably glance down to see what his feet are doing. After all, Mr. Buffett’s company Berkshire Hathaway is pretty well cashed up right now, having patiently waited on the sidelines recently while more reckless rivals dabbled in risky ventures.

Buffett’s latest bit of deft footwork: buying a $5 billion stake in Goldman Sachs. While calling any investment bank “blue chip” during this period of financial turbulence is a bit of a stretch, Goldman merits the stamp of quality if anyone does. Goldman is highly profitable, employs many of Wall Street’s smartest bankers, and – perhaps not coincidentally – was rare among peers for foreseeing troubles developing in bonds backed by U.S. home mortgages. So Buffett walks away with ownership in a well-run, top-tier (arguably the top-tier) investment bank on Wall Street. All for $5 billion. Sweet.

If you think, however, he supports such a smart deal for the U.S. taxpayer, you’d be dead wrong. Treasury Secretary Paulson’s plan seeks a towering pile of money to buy Wall Street investments that have gone sour largely because of the U.S. housing crisis. Even after getting a discount, the government would probably pay well above market value. If the investments turn out to be worth only $600 billion, $500 billion, or even $50, tough luck. For all his troubles, the U.S. taxpayer will own nothing of anything. Not even a third-rate boutique investment house or a paperweight bull.

Buffett has a lot of money under his thumb but little apparent appetite for acquiring, even at a deep discount, any of the risky mortgage-backed investments being offered to the American taxpayer. The same appears true of another high-profile cheerleader of Paulson’s plan. Bill Gross, a Master of the Bond Universe and the chief investment officer of Pimco, argues for the bailout on the pages of the Washington Post, even guesstimating how much the government could profit. So why isn’t he eyeballing any of this toxic waste for his portfolio? (Note: Gross is, however, eyeballing a well-paid role in managing the $700 billion pool of bad assets, should Paulson succeed in buying them.)

So as we seek advice from high-finance sages while trying to resolve the financial crisis, the advice bears repeating: Watch their feet. Not their lips.

Wednesday, 24 September 2008

Hands off the Ferrari

One of my favorite Hank Paulson quotes, as he tries to drum up support for a $700 billion rescue of Wall Street, was this one. (U.S. taxpayers are preparing to buy a bunch of bad mortgage-backed bonds to clean up the balance sheets of financial firms.) Paulson was responding to a proposal by those grumpy Democrats to cap executive pay packages at companies that receive bailout money.

“If we design it so it's punitive and so institutions aren't going to participate, this won't work the way we need it to work."

Restrict CEO compensation? L’audace! Haven't the red-faced chieftains of Wall Street been humiliated enough just by virtue of having to step forward and ask for help? In all seriousness, the Democrats' pay slap-down isn't one of the better ideas to attach to this bill. Either firms will find loopholes to ladle out compensation in new, innovative ways or they’ll face a talent drain. Reforming executive pay excesses on Wall Street should be hived off from the urgent matter at hand, fixing a financial crisis.

What's galling though is how Paulson’s quote shows him to be out of touch with reality. In truth, financial firms of all stripes are queuing eagerly to get a chunk of this $700 billion. Will a few gracefully demur, saying “no thanks, we’ll keep our toxic waste ” if they find out that aid comes at the cost of no longer being able to so richly compensate their top executives? Maybe. But somehow I doubt it.

Tuesday, 23 September 2008

A Question for Secretary Paulson

I chose the wrong week to go on vacation and must now catch up with the unread papers of an eventful week.

The demise of broker-dealers was news only in the manner it played out. But the business model was doomed. I wrote on this blog that for broker-dealers “to function, the system has to be unstable”.

The wording was slightly imprecise. I meant that to function, the system needed to be balanced on a razor’s edge. And for over a decade it was. But the ongoing turmoil in money markets disrupted the shaky balance beyond any hope of restoration.

AIG, too, was an easy bet. You could see something was rotten in the state of the company from the vehemence that it attacked standard accounting principles.

What I did not know was the extent of AIG’s involvement in the troubled money market funds. Then, under the cover of arranging an $85 billion bail-out of AIG, the Treasury announced that it would also rescue money market funds regardless of their affiliation. This happened on Thursday, after several funds “broke the buck”, meaning that their investors would lose some portion of their principal.

The news came out on Friday and after a few comments about how unprecedented it was, disappeared. Count on the mainstream media to ignore important news.

Let us see now. The U.S. Treasury is handing out money to money market funds to ensure that these funds, many of them with absolutely no affiliation with banks, broker-dealers or other financial institution, would preserve their $1 net asset value. Why? Note that this is taking place in the midst of a blood bath that forced Merrill Lynch to sell some assets for as little as 22 cents on a dollar. Why would it matter then if a money market fund's NAV dropped by a penny, to 99 cents? And why would that concern the U.S. Treasury?

The answer is that money markets are the critical link between industrial and finance capital, or, as your economics professor would say, between the financial markets and the “real economy” – the “real economy” always in quotation marks because he cannot define the term but expects you to understand it, very much like pornography.

The relation between the industrial and finance capital is a chapter in Vol. 5 of Speculative Capital. Here, I will have to be brief.

Assume your business purchases a machine for $12,000. The machine has an average life of 5 years, after which you have to replace it due to either wear and tear or obsolescence.

It is an elementary principle of accounting and finance that, ignoring the price change due to innovation, you have to set aside $2,400 every year for 5 years to create a reserve fund for the replacement of the machine. It is this money – $2,400 the first year, $4,800 the second year, and so on – that is placed in money markets and never in capital markets, the latter having a completely different function.

Money markets provide an extra income to funds while funds are waiting to be employed. But that income is absolutely secondary to preserving the original sum. This sum, when called upon, must be available for turning into fixed assets. If it falls short, it could not purchase the assets and the process of industrial production would suffer. It might even come to a halt. That is how money market is “related” to the real economy.

One of the funds in trouble was the famed Reserve Fund. Here is its “inventor” in an August '07 interview with the Financial Times. The man must have seen what was coming.
Bruce Bent, the inventor of the money market fund, has criticised the “flagrant abuse” of the concept – which he introduced in 1970 – that has come to light in recent weeks.

Mr Bent, who established the world’s first money market fund, the Reserve Fund, says the original idea behind the fund is being ignored. His displeasure stems from a sense that many money market funds have exposure to sectors or securities they should not be in, claiming his original concept was not designed to give investors any headline risk and should give them immediate liquidity and safety above all else.

“The money market fund was created to provide effective cash management, to guarantee at least a dollar in and a dollar back and beyond that, a reasonable rate of return,” Mr Bent says.
Like all fund managers, old Bruce is a practical man and cannot exactly or convincingly explain the nature of the “flagrant abuse” he is complaining about; when it comes to matters of theory, the “sense” will take you only so far. But he is right on the mark in describing the characteristics of money market funds. All traders know that, which is why on Thursday, the rates on the 3-month T-bills dropped to 3 basis points, which is to say, zero. I even heard that the market ran out of the T-bills. Thus, through rates and prices, the only way they know how, traders defined money markets for us: a place where the safety of principal trumps the interest income at all costs.

What about the Treasury secretary? Does he know the relation between the money markets and the real economy?

I must say, Yes. His hurried response to the shortfall in the money market funds is not sufficient proof. You could argue that it was the practical reaction of officials deluged by panicked calls from bankers and fund managers; the back office of any clearing institution on that Thursday must have been a scene to behold.

So I have other evidence, thanks to Larry Summers whose picture made The New York Times the other day as a potential Treasury secretary in the Obama administration. I remember him speaking in his capacity as the Deputy Treasury Secretary (to Bob Rubin) of the “benefits” of the Southeast Asian financial crisis. The time was February 13, 1998. The Wall Street Journal reported it on page A2 under the heading “U.S. Presses Japan to Stimulate Economy”:
’There has been more progress in scaling back the industrial policy programs in these countries in the last several months than there has been in a decade or more of negotiations,’ Mr. Summer said.
So Larry Summers knows that a financial crisis can setback industrial output and boasts of having achieved just that in Southeast Asia. He no doubt passed this knowledge to the Treasury staff as part of the “knowledge transfer” initiative that any responsible technocrat would undertake.

That brings us to the question. If the Treasury secretary and his underlings knew of the relation between money funds and the “real economy”, why did he not interfere to prevent the perversion of money markets that I described in the Credit Woes series? The perversion was a long time in the making and took place in the plain view of everyone in the market.

For that matter, where was Larry Summers, as Deputy Treasury Secretary, as Harvard President, as an eminent Financial Times columnist, to raise the issue? After all, it was under his watch and that of his mentor, Consigliere Rubin, that the money markets began metamorphosing into trading places.

These are rhetorical questions; I gave the answer in Vol. 1 of Speculative Capital, in discussing the dynamics of speculative capital and the way it operates through human subjects. But they are still questions to ponder in the midst of this crisis where grave-looking men in dark suits who try to end it find themselves grossly out of their depth.

(The last entry on Lehman bankruptcy had several errors, typos and an incomplete sentence. Blame them on the slow and spotty Internet connection I was using at the time. All are corrected, with apologies.)

Monday, 22 September 2008

The Big Lie Behind the Great Wall Street Bailout

At the heart of Treasury Secretary Hank Paulson's bailout plan is a Big Lie. The $700 billion plan is predicated on this Big Lie, concocted by financial firms holding a bunch of stinky investments. In brief, Wall Street claims they can't sell the investments (securities backed by deteriorating U.S. mortgages) because of the current upheaval in credit markets and nervousness about the U.S. housing market.

That's a lie. The truth is, the firms can’t sell the securities for nearly as much as they would like. So in other words, let's say they think they're holding investments worth 60 cents on the dollar, when a buyer right now might give them only 20 cents. Their argument: once the fear and panic abates in the financial markets, they'll be able to recoup the "fair value,” or the 60 cents on the dollar. But they need money now. So they're looking for a chump with deep pockets.

Enter the U.S. taxpayer, stage right. Paulson's plan would have the government snapping up armloads of lousy investments in order to bail out Wall Street. If you wonder, how do we figure out how much to pay, go to the head of the class. That’s the $700 billion question. Paulson's line is essentially, “Trust me, I'll take care of it.” In private, he has essentially conceded that the government will pay too much for what are bad assets. (See this excellent blog entry by naked capitalism for the inside scoop.)

With Lehman Brothers recently going bankrupt and mammoth insurer AIG getting $85 billion of cash, the U.S. government is rightly resolved to do something about the financial crisis, and sooner rather than later. That's commendable. But the Big Lie makes this Paulson plan rotten at its core, especially considering the irresponsible behavior of Wall Street's financial firms over the last few years.

When your drunken uncle Hal staggers in from a two-week bender, should you write him a blank check to cover his expenses, buy him a jug of moonshine, and send him back out the door?

Wednesday, 17 September 2008

Lehman’s Bankruptcy: An Event to Remember

The most outstanding characteristic of the “pragmatic man” is lack of conviction. He believes in no ideology, honors no conventions, adheres to no principles, follows no set rules, finds nothing per se wrong and rules out nothing categorically.

This is neither criticism nor moral posturing. It is an elaboration of what logically follows from the word “pragmatist”, what it implies. A pragmatist is ruled by the exigencies of the moment. He is a compromiser, a deal maker, a justifier, a fixer.

Central bankers are a pragmatic lot.

The news of Lehman and Merrill reached me at sea, in Alaska’s Inside Passage, to be exact. Without the phone reception and the spotty and outrageously expensive access to the Internet in the glaciated valley, I do not know the details, but the details do not matter. There is only one central question. Why was Lehman allowed to fail after long words about the systemic implication of the failure of much smaller Bear Stearns– and, if you want to go further back, Long Term Capital?

The Fed’s decision to let Lehman go under will be explained by the usual hangers on in the media as a courageous call and a necessary message to the officers of private enterprises that they must face the consequences of their actions. This will be celebrated as the triumph of free market and the application of tough love that everyone agrees corporate America desperately needs.

But central bankers are a pragmatic bunch and the Federal Reserve is no exception. It is inconceivable that the Fed would force a major broker dealer whose CEO sat on the board of directors of the Federal Reserve into bankruptcy for the sake of making an ideological point. The Lehman failure is a defeat, a setback. The Fed would have done everything within its power to save the firm. That it did not, because it could not, is the central story behind Lehman’s failure. In the Lehman crisis, the Federal Reserve reached the limits of its omnipotence. It was rendered impotent because it did not have the financial wherewithal to intervene.

In several entries on this blog, I have pointed out how the Fed’s Term Auction Facility, like the Bank of England’s Special Liquidity Scheme, was being abused by banks and broker dealers, Lehman included.

These “facilities” were created as a temporary solution to the seizure in money markets. The institutions holding impaired mortgage-related securities could pledge them with the central bank and receive Treasuries in return.

The idea was a “pragmatic” one. The activities of broker-dealers, for example, fell outside the Federal Reserve jurisdiction, but the facility was extended to them any way. It was believed by men who know nothing of the fundamentals of finance capital and explain everything in terms of human behavior that the scheme would somehow jump start the markets.

It did not turn out that way. The financial institutions immediately began swapping their existing junk securities for Treasuries. As the junk ran out, they sought and created junk specifically for the purpose of swapping it with Treasuries. Junk trading was back, except that now the central banks – the Fed in the U.S., and the BoE and ECB in Europe – were on the receiving end.

As the central bankers tried to clamp down on the practice, the markets fell.

The Bank of England’s money-market “reforms” that is in the works is intended, gingerly and with extreme caution, to finally get the Bank out of junk trading business. Hence, the comments of the Mervin King, its governor that the bank “will not and cannot solve the shortage of funding to finance bank lending”.

It was against this backdrop that Lehman’s funding needs turned into a crisis. Every day, the bank had to finance some $600 billion securities in the tri-party market. The Federal Reserve, having destroyed its assets through its Facility, could no longer take on such crushing load. It had to stand aside and let Lehman go down.

I will have more on this topic when I return.

Monday, 8 September 2008

Secretary Paulson Jumps the Gun – and Fires His Bazooka

Treasury’s takeover of Fannie Mae and Freddie Mac over the weekend meant that Secretary Paulson’s bazooka strategy had failed – but only because he chose to fire without having to do so. Otherwise, following his own words that “government support needs to be either explicit or nonexistent,” he could have extended an explicit government guarantee to Fannie and Freddie and achieve the same results he got with the takeover with much less suspense and fanfare. But the point, of course, was not to save Freddie and Fannie, but to bury them.

The extensive coverage of the event that followed added nothing of substance to the subject. That was par for the course for the media, as the readers of this blog know from the Destruction of Fannie Mae and Freddie Mac. A few tidbits, though, I found interesting.

One was Secretary Paulson’s using a secure video link from a bunker to brief the president. I understand the show-off, the ego trip: look Ma, I am talking to the president from a bunker. But there could not have been anything confidential about the plan that required secure communications. The Treasury’s plan was a rehash of the “prescription” – castration, really – that The Wall Street Journal presented on its July 10 editorial. I quoted it in the Destruction series. So, a few lines on any message board, with a link perhaps to the Journal article, would have sufficed.

As if to confirm this point, the New York Times reported that Mr. Paulson had also briefed Warren Buffet. No explanation was offered for this private briefing of a private investor by the U.S. Treasury secretary – doubly inappropriate because it took place in the context of an issue that involved, as per Secretary Paulson himself, a “conflict between public and private purposes”.

The Sage of Omaha then had this to say:
Secretary Paulson has made exactly the right decision for the country. He is minimizing the problem of moral hazard and maximizing the benefits for the housing market and for the smooth functioning of financial markets.
And you thought drivel – pure, unadulterated, absolute drivel – was the purview of politicians only.

I also learned that Fannie Mae CEO, Daniel Mudd had pleaded with Paulson to spare his institution. He pointed to his success in raising capital and emphasized that Fannie was in much better shape than Freddie Mac. He must have been certain that Fannie Mae could survive on its own, else he would not have dared to press the point in an atmosphere of the crisis. But his reasoning went nowhere. Paulson told him that “Freddie was nearing a crisis and that, in the eyes of the markets, the companies were joined at the hip”.

And why was Freddie Mac nearing a crisis?

It needed capital. When the CEO, Richard Syron went to New York to seek investors, The New York Times reported, “potential investors told Mr. Syron there was too much uncertainty around the Treasury’s intentions; if investors acted now, and Freddie was later seized by regulators, they would lose everything they had invested.”

So the reason Freddie Mac could not get capital was the uncertainty about the actions of Treasury. And that – Freddie’s inability to raise capital because investors were unsure about the Treasury's actions – was the reason that Fannie Mae also had to go.

None of this is will surprise the readers of this blog who read the Destruction series. Unbeknown to the CEOs, the fate of Fannie Mae and Freddie Mac was sealed long before the first weekend in September 08. That is why the Treasury’s rescue plan now “bans [Fannie/Freddie] from lobbying the government, putting an end to their ability to use their political machine on Capitol Hill.”

This is the equivalent of creating a “no fly zone”, proof that opponents are in the driver's seat and the sign that they are planning to have their way with you.

A matter of a small indignity remained. The New York Times said:
The seizure of Fannie and Freddie is all the more surprising because, as recently as late March, Washington viewed the companies as saviors of the housing market and the economy, rather than as risks to them. Instead of requiring Fannie and Freddie to scale back, regulators gave then a green light to buy and guarantee more and bigger mortgages.

On March 19, James B. Lockhart, their chief regulator, dismissed swirling rumors about their financial health. “The actions we’re taking today,” Mr. Lockhart declared, referring to a decision to ease restrictions on how much capital they were required to hold, “make the idea of a bailout nonsense in my mind. The companies are safe and sound, and they will continue to be safe and sound.
This remembrance of the events past is hard on Paulson and Lockhart. It makes them look like fools who misread the situation even after the collapse of Bear Stearns.

Such characterization would be fine with both men, certainly with Lockhart. That is because the real story is even more damning.

The plan, you recall from the Destruction series, was to take out the agencies. The job had to be done in a “clean” and controlled manner; it would be foolish to do otherwise. But in the midst of the plot, the unpredictable intervened: the credit market froze. After the collapse of Bear Stearns in March, panic set in. In desperation, the attention turned to two healthy institutions that, up to that point, had been incessantly maligned. Suddenly, the tune changed, hence Lockhart's passionate declaration that “the companies are safe and sound, and they will continue to be safe and sound”. The second half of the statement is a wishful thinking, almost like a promise you know you could not keep. Anyway, by then it was too late.

I will have more to say on this subject in Vol. 5 of Speculative Capital.

Sunday, 7 September 2008

The Critical Role of Interest Rate Swaps in Financial Markets and the Real Economy

Sometime in the fall of 1990, during a lunch conversation with colleagues in what was then Credit Lyonnais, I brought up the idea of writing a book on swaps. The head of HR who had some knowledge of the publishing industry thought I was setting myself up for disappointment. Publishers would not accept a book proposal without an introducing agent, and no agent would take a writer as a client who was not already a published author. Like first jobs and the experience requirement, it was one of those well-known catch-22s, he said.

The same evening – it was on a Thursday – I wrote a 4-page proposal and sent it to Dow Jones Irwin. On Monday they called and offered a contract.

Valuation, Trading and Processing Interest Rate Swaps came out in 1993 under the imprint of Business One Irwin – even then the publishing industry was in turmoil – and, according to the statistics of the legendary McGraw Hill bookstore in New York anyway, became an “industry bestseller”; industry meant technical books in finance. I received a princely sum of $7,500 and many compliments. One mildly critical comment stood above the rest. An academic reviewer wrote: “The chapter on operations is interesting in that it addresses issues not discussed elsewhere but I doubt many people would be interested in how it works”.

I had almost forgotten the book until a friend recently suggested adding it to the list of the books on the blog as a part of the blog’s (very) gradual overhaul.

Interest Rate Swaps has been out of print for a long time. But interest rate swaps are going strong as ever. In fact, though I did not know it then, the spectacular growth of the swap market in the 80s was the driver and the resultant of the rise of speculative capital.

An interest rate swap is simple in concept. Two sides agree to the exchange of interest payments based on a notional amount. (“Notional” because it does not change hands and merely serves as the reference for the calculation of interest amount.) One party pays fixed rate; the other, variable. The variable index is generally the London Interbank Offered Rate, or Libor (pronounced like MY DOOR.) It typically resets every quarter.

Operational issues aside, there is little to add to this description. But nothing exists out of context. Taken into capital markets for which it was designed, the swap structure proved quite revolutionary. It made possible arbitraging corporate credit and interbank lending markets.

The clue to this critical function is in the Libor index, which pertains to the rate banks charge one another. Interest rate swaps enable corporations to borrow cheaper in the variable rate Eurobond market and swap it to a fixed rate.

The quantitative impact of this funding mechanism was phenomenal. Twenty years ago, 80% of the corporate borrowing was through bank financing and 20% through bond market. Today, the ratio is reversed; it is 80% through capital markets and only 20% through bank financing.

Far more important, however, was the qualitative transformation of the markets. You see, if you could use swaps to arbitrage the cheaper inter-bank lending market and the long-term capital market rates, why stop at corporation? Why not bring in municipalities to the game as well, to take advantage of the “efficiencies” of the modern financial markets and collecting no so insignificant fees and bonuses in the process?

That is precisely what transpired. Hence, the rise of auction-rate securities (ARS) and the option tender bonds (OTBs). Under the relentless pressure of speculative capital which aims to shorten the trade horizons, the Libor reset was also reduced to its irreducible overnight frequency. In this way, the overnight swap index (OSI) was born.

Note here that OSI and the Fed Funds rate serve the same exact purpose. They are the rates that banks can borrow overnight from each other (OSI) and the Fed (Fed Funds). Hence, it stands to reason that the difference between them should only be a few basis points (accounting for the higher credit quality of the Fed). That was indeed how it was until summer '07. Since then, the persistently large spread between OSI and FF, over 60 basis points, has provided one of the most compelling signs of continued malaise in the markets.

If you sleep with dogs, you wake up with fleas. If the corporate and municipal bond market are linked to the interbank lending market through swaps, then they are bound to suffer the consequences of any dislocation in the financial markets. Somehow the top central bankers and top economist and top fund managers in Jackson Hole did not seem to grasp this obvious link between the financial markets and what they call – always in quotation marks – the “real economy”.

In Vol. 5 of Speculative Capital, I will show the exact manner in which crises in the financial sector impact the industrial production and service activities. In the mean time, read the following news stories that provide useful background material on auction-rate securities, option tender bonds and the role of interest rate swaps.

The last one is the most entertaining. It deals with the question of the “reliability” of Libor because the index did not behave the way college textbooks and the learned professors had said it should. There were serious and protracted discussion about reforming or replacing the Libor until the discussion slowly faded away, one hopes from embarrassment. There never was a more egregiously foolish shooting of the messenger.

Sense of crisis growing over interbank deals (FT, September 5, '07)

In particular, the cost of borrowing funds in the three-month markets – as illustrated by measures such as sterling Libor or Euribor – is continuing to rise, suggesting a frantic scramble for liquidity among financial groups. This trend is deeply unnerving for policymakers and investors alike, not least because it is occurring even though the European Central Bank and the US Federal Reserve have taken repeated steps in recent weeks to calm down the money markets. Or as UniCredit analysts say: “The interbank lending business has broken down completely … it is a global phenomena and not restricted to just the euro and dollar markets.”

Strategies reborn and lessons learnt – hopefully (FT, October 8, '07)

The TOB programme is a trust that borrows short-term money to buy US municipal bonds. The people setting it up ... buy long-dated US munis with money borrowed at Libor. After paying for a hedge against a rise in Libor, they might net 30 to 50 basis points, but they can leverage that trust up perhaps 12 to 14 times ... The managers have the option of liquidating the trust in case things go against them in some way, or if they decide they want to wind up the business. What they had not counted on was, of course, what happened. In the summer crunch, Libor blew out as banks became suspicious of each other. At the same time, like all non-sovereign bonds, US munis came under suspicion.

Global funding pressures intensify (FT, April 15, '08)

Strains across money markets intensified yesterday and are approaching levels last seen in mid-December ... This was illustrated by higher swaps rates, which compare the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other. In the UK, this spread known as the overnight index swaps (OIS) rate, rose above 100 basis points yesterday and in the US increased to 80.6bp. … These are highly elevated levels and compare with swap rates of around 15bp before the credit crunch emerged last year.

Slowly does it, as calls grow for Libor shake-up (FT, April 22, '08)

The British Bankers’ Association has opened the door to “evolutionary change” in how it calculates London Interbank Offered Rate – Libor – in response to growing criticism about the accuracy of the global benchmark for borrowing costs … The rate has traditionally been considered a key barometer of financial stress and swings in Libor can have big economic implications since many loan and derivatives contracts are based on it ... However, bankers fear the index has become distorted in recent months, particularly in dollar markets, because it is calculated according to bank’s perceived funding costs rather than actual trades.

The emphasis on Libor, OTB and ARS in these stories tends to obscure the central role of interest rate swaps. But that role is ever-present; it is central to the stories. No student of finance can afford to be in the dark about these critical tools of arbitrage. Good finance teachers will see to that.

Monday, 1 September 2008

(What Lies Behind) The Descent of Man

I had planned to write about this story earlier but got distracted by the events in the financial markets.

On August 6 this year, 11 climbers died on the “K2”, the world’s second tallest mountain.

Maurcie Isserman wrote an insightful Op-Ed piece in the New York Times in which he faulted the every-man-for-himself attitude of the climbers and contrasted it with the more chivalrous conduct of bygone years. I am quoting select passages here, but you should read the piece in its entirety.
WILCO VAN ROOIJEN, a Dutch mountain climber, managed to survive the debacle this week that took the lives of 11 others in Pakistan on K2, the world’s second-highest peak. Describing the chaotic events that ensued when a pinnacle of ice collapsed and swept away fixed ropes that climbers from several expeditions high on the mountain had counted on to aid their descent from the summit, Mr. van Rooijen lamented: “Everybody was fighting for himself, and I still do not understand why everybody were leaving each other.”

Fifty-five years ago this month, Dr. Charles S. Houston, America’s premier Himalayan mountaineer, led a team of seven Americans and one British climber attempting a first ascent on K2. They made steady progress up the mountain, and by Aug. 1 all eight climbers had reached a campsite at 25,300 feet. From there, given good weather, they expected to reach the 28,251 foot summit in two days.

Instead, they were pinned down by a blizzard in their high camp for the next week. And one member of the team, Art Gilkey, who was on his first Himalayan venture, was struck down by a case of thrombophlebitis, a clotting in the veins, in his left leg. It left him unable to walk and in danger of death if a blood clot were to reach his lungs. Houston and the others knew that there was little chance that they could carry an incapacitated man 9,000 feet down treacherous slopes to the safety of base camp. But they did not for a minute consider leaving their teammate behind.
Isserman ended the essay by comparing the conduct of climbers then and now:
Houston himself summed up the highest ideals of expeditionary culture when he wrote of his K2 comrades: “We entered the mountains as strangers, but we left as brothers.” Today in contrast, as was evident last week on K2, climbers enter the mountains as strangers and tend to leave the same way.
This ending suffers from a triple fault. It is didactic. It is nostalgic. And it stops where it must begin.

Why did the spirit of cooperation decline so drastically in the past 55 years to the point of nonexistence? What explains this descent of man?

The answer is the ascent of “economic man”.

Economic man is the driver of the Western economic theories. He is a constantly calculating machine ruled solely by the considerations of personal profit and loss, pleasure and pain avoidance, risk and reward. By virtue of this characteristic, he is labeled “rational”. This rationality is not in the Kantian, but the Shylockian, sense; the economic man is “rational” because he strives to maximize his profits without regard to others.

After WWII, with the influence of the US reaching beyond economics and into the cultural and social landscape, the “ethics” of economic man gradually worked their way into the psyche of the Western public. Still, the “progress” was slow and the economic man mostly remained confined to college textbooks and academic settings. The watershed event was the collapse of the Bretton Woods system that, in giving rise to speculative capital, created the perfect milieu for the coming-out of the economic man. He came out all right, in-your-face and even belligerent, not only in academic theories but also in the media, movies and books. Milton Friedman was his most fanatic advocate; he strove to create a social-moral system to always put the economic man on the right.

Here is this “father of monetarism” in a June 5, 2005 interview with the San Francisco Chronicle. The subject of the interview was Friedman’s “bold” idea of privatizing the Social Security that, the paper claimed, was becoming “mainstream”:
“I have always been opposed to social security,” Milton Friedman said in a recent interview at his home in San Francisco. “I think it is a very unethical program” … What about the fact that Social Security has reduced poverty among the elderly? “Well,” he replied, “what it has done is transfer a lot of income from the young to the old. It is certainly true it has made the old people of the United States the best treated old people in the world”. But why is that a bad thing? “Oh,” he replied. “It is not a bad thing for them, but what about the young?”
I quoted this interview in Vol. 3 of Speculative Capital and commented:
The “bold” economist reverses the meaning of ethical by changing its reference from others to the self: every man for himself and may the devil take the hindmost. To the intellectual architects of the particular brand of economics practiced in the U.S., every man is on a desert island.
The climbers who died or abandoned their friends on the K2 were the climbers of our time. They were taught – conditioned, really – to maximize their own self interest. In the chaos of an accident on the mountaintop, immediately running for cover must have seemed as the most rational course of action. It was in keeping with the ethics of the time.

Maximizing one’s interest, however, is not always the “optimum” course of action. You do not need to be a follower of Rumi to understand that. The chaos in the financial markets which I described in the 10-part Credit Woes series offers ample evidence of that universal truth.